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A common question traders ask in our courses is how much leverage should I use? In our trading courses, we frequently talk about using less than 10 times effective leverage.

To get started, let’s look at what leverage is and why it is important to generally use less leverage rather than more leverage. Later on, we will explain the simple calculations needed to determine the effective leverage on your trading account.

What is leverage?

Leverage refers to using a small amount of one thing to control a larger amount of something else. As individuals, we use leverage to some degree in a portion of our daily lives.

For example, when you buy a house on credit, you are actually leveraging your personal balance sheet. Let’s say you wish to buy a $200,000 house but you don’t have that much cash on hand. So you put a 20% down payment of $40,000 on the house and make regular payments to the bank. In this case, you are using a small amount of cash ($40,000) to control a larger asset ($200,000 house).

In the stock market, many margin accounts allow you to lever up your purchases by a factor of 2. So if you have a $50,000 deposit into a margin account, you are allowed to control $100,000 of assets.

How is Effective leverage calculated?

To determine the amount of effective leverage used, simply divide the larger asset by the smaller instrument. So in our housing example, we divide the value of the house by the equity in the house which means the house was levered 5 times.

There is simple formula to determine your account’s effective leverage. This formula is printed below:

Total Position Size / Account Equity = Effective Leverage

EXAMPLE:

Now, let’s take a hypothetical trader and calculate their effective leverage in their forex account. Let’s assume that a trader with $10,000 equity has 3 positions open noted below:

20,000 short the EURUSD

40,000 long the USDCAD

10,000 long AUDJPY

The traders total position size is 70,000. (20k + 40k + 10k)

Using the formula noted above, the trader’s effective leverage is 7 times.

(70,000 position size / $10,000 Account Equity = 7 times)

How do I know how much leverage to use?

There is a relationship between leverage and its impact on your forex trading account. The greater the amount of effective leverage used, the greater the swings (up and down) in your account equity. The smaller the amount of leverage used, the smaller the swings (up or down) in your account equity. In our trading courses, we frequently talk about using less than 10 times effective leverage.

Just because you have access to a higher amount of leverage in your account does not necessarily mean you want to use all or any portion of it. Think of it like an automobile or motorcycle. Just because the machine could run at speeds of 200 miles per hour, that does not mean YOU necessarily need to drive it that fast. You see, the faster you drive it, the more likely you are to get into an accident. Therefore, you are in greater risk of bodily injury driving at higher speeds and leverage is similar to that analogy.More leverage puts your trading account at risk.

Why do we encourage lower leverage?

When you use excessive leverage, a few losing trades can quickly offset many winning trades. To clearly see how this can happen, consider the following example.

By using lower leverage, Trader B drastically reduces the dollar drawdown of a 100 pip loss.

For these reasons, that is why in my trading I choose to be even more conservative and oftentimes use less than 10 times leverage. The appropriate amount of leverage for you will be based on your risk appetite. An aggressive trader may utilize effective leverage amounts closer to 10 to 1. More conservative traders my utilize 3 to 1 or less.

Why does the average trader lose money? We studied over 30 million trades to help you become a more consistent trader. On page 4 of our Traits of Successful Traders Guide, we discuss the most common trading mistakes.

About your FOREX.com Demo Account

A demo account is intended to familiarize you with the tools and features of our trading platforms and to facilitate the testing of trading strategies in a risk-free environment. Results achieved on the demo account are hypothetical and no representation is made that any account will or is likely to achieve actual profits or losses similar to those achieved in the demo account. Conditions in the demo account cannot always reasonably reflect all of the market conditions that may affect pricing and execution in a live trading environment.

Leveraged trading in foreign currency or off-exchange products on margin carries significant risk and may not be suitable for all investors. We advise you to carefully consider whether trading is appropriate for you based on your personal circumstances. Forex trading involves risk. Losses can exceed deposits. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading.

FX Publications Inc (dba DailyFX) is registered with the Commodities Futures Trading Commission as a Guaranteed Introducing Broker and is a member of the National Futures Association (ID# 0517400). Registered Address: 32 Old Slip, Suite 803; New York, NY 10005.